Tommy Wilkes and Abhinav Ramnarayan

LONDON, (Reuters) – Britain seems like a place investors need to have a buffer against inflation. However many believe that domestic bond trades designed with this in mind are overstating price pressure and making them too costly.

Because their interest and principal payments increase with inflation, they are more popular than those linked to government bonds.

As inflation fears have been fueled by shortages of labour and other factors, interest in these commodities in Britain has skyrocketed.

British linkers are in high demand even during normal times from pension funds. This is especially true for defined-benefit schemes, which promise to pay inflation. This increases breakevens and drives yields to be lower.

Instead of the Bank of England consumer price index they use, the RPI (retail price index) is the return that they receive. Inflation expectations should be lowered as the RPI is 0.8% to 1.1% higher than CPI.

Even after accounting for this gap, fund managers claim they are now being forced to search for the same protection abroad as the UK market. Investors positioned for lower inflation have already been squeezed, making them even more disconnected from the fundamentals

One-year index linked gilts have a current inflation rate of 5.8% while five year linkers display it at 4%.

BoE anticipates that consumer price inflation will briefly rise above 4% in 2021, and then recede.

Investors feel that there is a poor return on money in the linker marketplace, especially after the recent repricing of the BoE’s tighter policy.

UK 2-year yields increased by 42 basis points during the past month. U.S. 2-year yields were 14 bps lower and German yields just 5 bps.

DEMAND/SUPPLY INMBALANCE

“It is too costly for us. John Taylor (NYSE:) co-head European Fixed Income at AllianceBernstein (NYSE 🙂 said there were cheaper alternatives.

Taylor bought British government bonds and added exposure to inflation-linked bonds in Australia, the United States, and other countries where prices are not too high.

The UK’s 2-year, 2-year forward inflation swaps for the UK predict an inflation rate of 4%. This is double the BoE target. It also rises from 3.83% in September.

While the U.S.-equivalents in euro zone have moved further, they are still much closer to inflation targets set by their central banks at 2.77% & 1.78% respectively.

Paul Rayner from Royal London Asset Management, Head of Alpha Strategies has also discarded UK links in favor of Australian, U.S., and Euro zone inflation-linked bonds as well as Japanese where breakevens can be close to zero.

They offer better opportunities to position yourself for increasing British and global inflation, Rayner stated, calling UK links “extremely undervalued”.

A major bank’s inflation securities trader said part of the rise in profitability is down to the “inflation tourists”, which are investors that suddenly seek protection but are not usually active on the market.

This has exacerbated the imbalance between demand and supply in a market with 1.7 trillion pounds ($2.3 trillion), mostly from pension fund liabilities linked to inflation, seeking products that are less than 500billion pounds.

According to the trader, “This type of camp increases pressure for breakevens go higher which typically means that headline inflation will begin peaking then reverse,” he said.

Morningstar data indicates that assets held in euro-domiciled sterling inflation-linked bonds funds – which are proxies for the larger linker market — reached 16.9 million euros in August. This is just short of the record-breaking august, Morningstar data show.

They received 876 millions euros in net cash during the eight first months of 2021, their largest haul since 2017.

Graphic: UK breakeven inflation soars https://fingfx.thomsonreuters.com/gfx/mkt/myvmngoxypr/breakeven%20inflation%20oct%2012.png

INFLATED EXPECTATIONS

Fahad Kamal was the chief investment officer for Kleinwort Hambros. Markets get excited about slowing growth and the demographics.

Kamal said that it seems like inflation is being overstated by just a few percentage points based on historical data. He has turned to U.S. securities as a better indicator of global inflation pressures.

Savvas Savouri (chief economist at Toscafund asset Management), believes that the CPI basket needs to be overhauled as it fails to account for technology’s deflationary effect.

Linkers suggest a CPI of 3.2% within five years, but he anticipates that actual readings will be between 2% and 2.5%.

($1 = 0.7355 pounds)